Investment risk: What the fragile five also share


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Brazil, India, Indonesia, South Africa and Turkey have more in common than macroeconomic numbers.

Morgan Stanley’s currency research document published last summer, entitled ‘The fragile five’, has become the blueprint for an emerging market sell-off. The fragile five – Brazil, India, Indonesia, South Africa and Turkey – has become the bearish counterpart to the Brics bull of the previous decade.

The common factors to which the research draws attention are high inflation, large current-account deficits, challenging capital flow prospects and potentially weak growth. But these are just outward signs of other predicaments, which are political as well as economic.

It is no coincidence that all five countries seem especially uncertain investments because they all face elections this year: all five (unlike China, for example) are democracies. The report does not mention these political commonalities, but it is surely linked to the numerical signs of economic strife in these countries. When countries have sustained cheap inflows of capital – particularly when elections are at hand – governments are more likely to use it for quick fixes to economic demands: hence the larger current-account deficits.

With less cheap money, the fragile five must deleverage, which will have an adverse impact on growth, particularly as, in recent years, money has gone on current spending (public-sector wages, consumer borrowing and the like) rather than on investments in underlying growth potential.

To some extent this is an inevitable cycle in open market economies, particularly in democratic developing countries. A floating currency can be a shock absorber and in theory an automatic adjuster of the current account. But on the downside, it often means even more cyclicality in how these countries save and invest.

For the fragile five, the only practical way to avoid falling into a trap is reform: improve the business climate and if necessary (as in Turkey) further reduce external vulnerabilities via the development of local markets. Infrastructure investments will be a by-product.

Arguably, what growth they have enjoyed over the past decade was a result of reforms to the state when these governments were younger. But parties that have enjoyed being in power for a decade or two are also a characteristic of all five – not so Mexico or Poland, for example.

These governments are increasingly unpopular, partly because entrenchment has bred complacency, stagnation, and a return to the corrupt practices of old. They gained power in global geopolitical shifts. Changing dynamics in capital flows helped propel those shifts, and could propel new shifts now.